The Baby Boomers are retiring in large numbers over the next ten years and the impact on the economic landscape of America will be dramatic. This post will examine those trends and the likely impact on business valuations over the next several years.
The Baby Boomers are retiring in large numbers over the next ten years and the impact on the economic landscape of America will be dramatic. This article will examine those trends and the likely impact on business valuations over the next several years. From a 40,000 foot view the number of businesses that change hands will mirror the number of baby boomers that are retiring.
According to Federal Reserve's Survey of Consumer Finances, in 2001, 50,000 businesses changed hands. That number rose to 350,000 in 2005 and is projected to increase to 750,000 by 2009. Price Waterhouse reported in a Trendsetter Barometer Survey of Business Owners that 51% were planning on selling their company to another company compared with 18% anticipating passing on the business to a family member and 14% planning a sale to the company's management.
The trends point to more than a doubling in the number of businesses that will hit the market looking for a buyer by 2009. Simple economics and supply and demand would suggest that unless the number of buyers increases significantly, there will be an erosion in valuations for business sellers during this rush to the exits. Compare that to the relatively robust environment business sellers have enjoyed over the past 3 years. This period was supported by unprecedented Private Equity investments in addition to the available cash from corporations with rising profits.
Now we have the sub-prime situation impacting the available funds that the Private Equity Firms were using to highly leverage their mega deals and drive up transaction values. The good news for most privately held companies, 99.9% of your companies will not fall into the mega deal category. A larger privately held industry player or a publicly traded company is the most likely buyer. The economics are still positive for these buyers looking to add customers, product lines, technology or all three. A publicly traded company can still buy a private company for a good price and not dilute their share price.
Given this backdrop, what is a business owner who is anticipating selling his business in 2010, to do? Move up your sale timeframe, but not necessarily your exit timeframe. No, I am not talking in riddles. What I mean is that you should take your chips off the table with a sale transaction sooner rather than later. Your eventual exit could be in 2010 after working full time for the new owner for 1 year to transition customer relationships and intellectual property, followed by a limited consulting engagement for two years.
Too many business owners view their business sale and their retirement as a simultaneous event and end up delaying the sale to the day they want to stop working. That misperception can be very costly. Too many owners wait too long and end up selling because of a negative event like a health issue, loss of a major account, a shift in the competitive landscape, or just plain burn out. As you can see, none of these major reasons for selling puts you in a favorable negotiating position. As a general rule, the faster you want to disassociate yourself from your business, the more the buyer will want to deduct from his purchase price. Your desire to leave quickly is a red flag of risk to the new owner.
Your best outcome is to sell your business near the top and stay involved as an employee or consultant for a reasonable period. If you look at the transaction structures that are popular in the acquisition of closely held businesses, this approach makes a lot of sense. The more a business depends on the owner for its success, the greater the risk to the buyer. The greater the percentage of a selling company's projected earnings that is dependent on future new sales, the lower percentage of transaction value that the seller will receive as cash at closing. The greater the concentration of company sales to a small number of customers, the lower the price and the greater the earn-out component of transaction value.
Most privately held family businesses have one or a combination of these value detractors. Your selling strategy can mitigate the negative impact on selling price. By exiting before the necessity of exiting, your sales trajectory will more than likely be on the increase than on the decline. Buyers pay a premium for growth and discount for flat or falling sales. Unless your entire revenue stream is contractually committed over the next several years, most buyers will introduce an earn-out as a component of the total transaction value. This is a risk avoidance strategy that ties the total acquisition price to the future performance of the business post acquisition. It is also designed to keep the business seller engaged in the near term performance of the business.
In spite of the normal response from business sellers who want the entire sale price in cash at close, we believe that under the proper circumstances and properly memorialized in the definitive purchase agreement, earn-outs can be a big win for a seller. We normally try to tie the earn-out to future revenues of the acquired property. That is usually very easy to measure and to audit if necessary. Earn-outs based on future EBITDA or division profitability are more problematic because of the greater possibility for interpretation by the buyer. You all of a sudden get an accounting entry of corporate overhead in your financial reconciliation and your profit disappears.
Count on your original champion who negotiated your agreement not being involved by the end of the earn-out period. Make the agreement air tight in terms of how it is interpreted. A subtlety that we negotiated into an earn-out for a client was that the earn-out would be paid based on the greater of the sales price for the seller's product or 80% of list price, whichever was greater. You see, we can not control how the buyer runs the business once he has the keys, but we can control how the earn-out is calculated. This prevented the buying company using the seller's product as a loss leader in combination with their other products and shifting the revenue to other products at the seller's expense.
If you look at this preferred structure in conjunction with your sell now, exit later strategy, it can work in your favor. Wouldn't you want to be fully engaged and energized during your earn-out period and drive the value of the earn-out? As part of the new company, you now have 325 installed accounts instead of 25. Your sales force is now 25 strong compared to 2 sales people from your prior company. Your advertising budget is twenty times your old budget. You now have a network of 50 manufacturers reps supporting sales. Your new company's access to growth capital dwarfs what was available to your little company. Do you think you have an environment where you can achieve a sales growth far greater than what you could do on your own?
The key is to negotiate the earn-out that gets you to a transaction value comparable with an all cash at close offer that assumes your company sales grow at their historical rate.
For example, your offer if you back the buyer into the all cash at close offer is $5 million. Compare that to a deal that would provide you $3.5 million at close and another $1.5 million in earn-out if sales grew at 10% per year (your company's historical rate) for the next three years. Our contention is that the earn-out deal could be far superior. Given the much greater distribution power of the new owner, you could reasonably expect sales to jump by 25% per year, driving your earn-out to $2.5 million and resulting in a $1 million improvement in transaction value. You want to be fully engaged to achieve this result and that is exactly what the buyer wants.
As a business seller you have many factors that can greatly impact your selling price. Getting multiple buyers involved is probably number 1. A very close second, in the near term future is the timing of your sale. The economic trends are against you postponing the sale part of your exit. You can always sell now and retire later.
Saturday, June 28, 2008
Reduce Capital Gains Tax in the Sale of a Business
The sale of your business will be the largest financial transaction in your life. As a business owner, you have benefited from the growth in the value of your business tax free. Unfortunately when you sell your business, it is time to pay up with capital gains taxes. This post discusses an approach that allows you to again defer your capital gains taxes, maximizing the returns from your business sale.
Hopefully, before selling a business, you meet with a CPA or tax accountant and get an estimate on how much of your proceeds will be going directly to Uncle Sam if you pay them in a lump sum at time of sale. You don't want to save this surprise for after all is said and done, because not only will it most likely be a shock, but you will have given up your chance to do anything about it.
Planning is everything. For this article I will assume you are not doing a 1031 business exchange, that is selling your business and buying another similar business taking into consideration all the IRS guidelines and timelines. It's pretty rare to see this, but it can defer all of your capital gains tax if done correctly. A 1031 Exchange is more commonly implemented with real estate.
Depending on how the business is sold, the gains may be taxed as long term capital gain, short term capital gain, ordinary income, etc. and if you are selling an asset in a C-Corp you may face double taxation. So, the idea is to minimize your tax bill and maximize your proceeds no matter what situation you are in.
One option is with a Self Directed Installment Sale. The structure must be in place before the buy/sell agreement is signed. The gist is to receive the sale proceeds in installments and only pay capital gains tax as you receive the income. This has the effect of allowing the majority of money you would have paid immediately in taxes to continue earning compounded interest for you for many years, thus increasing your bottom line by a significant amount.
The details are a bit too complex to fully outline in a short article, but both an LLC and a Trust are created for you and set up meet IRS criteria for favorable taxation of installment sales. Your asset gets transferred to the LLC prior to sale, and your buyer purchases from your LLC. The trust buys the shares of your LLC from you via an installment agreement and you pay taxes on your gain only as you receive the payments.
You, the seller, are able to control when the payments begin and how long they will be spread out. This allows for maximum flexibility to control your income, and plan for future tax savings as well. Since your buyer paid cash in exchange for your property, you are not dependent on them to make the installment payments and you have transferred the risk of refinance or default. This is done by using an independent third party administrator and your money is safely invested in a principle protected insurance product to be used solely for the purpose of paying the installments.
If you pass on before receiving all of the payments due, the remainder of the installment payments pass to the beneficiaries of your choice.
Seeing an example of a taxed sale vs. a Self Directed Installment Sale side by side will show you how much of a difference in overall return this strategy will provide. This can make the process of the sale more palatable and provide a dependable income stream for retirement.
The tax benefit of this approach is similar to your 401K or IRA account. You reduce your current income by the amount of your annual contribution and thus defer the tax you would have paid on that income amount. Those funds are invested in stocks and bonds and grow in value, sometimes dramatically, for the period before you retire and start taking distributions. When you start distributions, the amount is treated as ordinary income and you are taxed at your much lower (you are no longer working and earning a big salary) income tax rate at the time.
The Self Directed Installment Sale allows you to similarly defer your capital gains tax from the sale of your business. Instead of paying all of your capital gains at time of sale, you set up your SDIS to pay out your sale proceeds over time. If you pay all of your capital gains tax at time of sale, that money is gone forever. However, with this vehicle, you spread your receipt of the sales proceeds out over, 15 years for example. When you receive your distribution, you are then taxed for the portion of that distribution that is attributed to the capital gains - generally about 15%.
The difference in after tax proceeds are dramatic and are demonstrated by a complex analysis called an illustration. I will try in an abbreviated fashion, however, to demonstrate the potential impact. If you sold your business and you had a capital gain of $3.46 million, your lump sum capital gains tax payment at a 15% rate would be $519,000. In the SDIS you would keep the entire sale proceeds of $3.46 million and take distributions over a 20 year period or whatever period you chose. You receive an annual payment over 20 years, that would consist of 1/20 of the principal, 1/20 of the capital gains, plus investment returns.
If we did an illustration of this case and compared selling the business and paying all the capital gains up front and invested the remaining proceeds in a 6.85% compound growth portfolio versus the SDIS paying 1/20 of the capital gains annually, you would gain an $831,000 advantage in after tax proceeds. Not to bad for a little advanced planning.
Hopefully, before selling a business, you meet with a CPA or tax accountant and get an estimate on how much of your proceeds will be going directly to Uncle Sam if you pay them in a lump sum at time of sale. You don't want to save this surprise for after all is said and done, because not only will it most likely be a shock, but you will have given up your chance to do anything about it.
Planning is everything. For this article I will assume you are not doing a 1031 business exchange, that is selling your business and buying another similar business taking into consideration all the IRS guidelines and timelines. It's pretty rare to see this, but it can defer all of your capital gains tax if done correctly. A 1031 Exchange is more commonly implemented with real estate.
Depending on how the business is sold, the gains may be taxed as long term capital gain, short term capital gain, ordinary income, etc. and if you are selling an asset in a C-Corp you may face double taxation. So, the idea is to minimize your tax bill and maximize your proceeds no matter what situation you are in.
One option is with a Self Directed Installment Sale. The structure must be in place before the buy/sell agreement is signed. The gist is to receive the sale proceeds in installments and only pay capital gains tax as you receive the income. This has the effect of allowing the majority of money you would have paid immediately in taxes to continue earning compounded interest for you for many years, thus increasing your bottom line by a significant amount.
The details are a bit too complex to fully outline in a short article, but both an LLC and a Trust are created for you and set up meet IRS criteria for favorable taxation of installment sales. Your asset gets transferred to the LLC prior to sale, and your buyer purchases from your LLC. The trust buys the shares of your LLC from you via an installment agreement and you pay taxes on your gain only as you receive the payments.
You, the seller, are able to control when the payments begin and how long they will be spread out. This allows for maximum flexibility to control your income, and plan for future tax savings as well. Since your buyer paid cash in exchange for your property, you are not dependent on them to make the installment payments and you have transferred the risk of refinance or default. This is done by using an independent third party administrator and your money is safely invested in a principle protected insurance product to be used solely for the purpose of paying the installments.
If you pass on before receiving all of the payments due, the remainder of the installment payments pass to the beneficiaries of your choice.
Seeing an example of a taxed sale vs. a Self Directed Installment Sale side by side will show you how much of a difference in overall return this strategy will provide. This can make the process of the sale more palatable and provide a dependable income stream for retirement.
The tax benefit of this approach is similar to your 401K or IRA account. You reduce your current income by the amount of your annual contribution and thus defer the tax you would have paid on that income amount. Those funds are invested in stocks and bonds and grow in value, sometimes dramatically, for the period before you retire and start taking distributions. When you start distributions, the amount is treated as ordinary income and you are taxed at your much lower (you are no longer working and earning a big salary) income tax rate at the time.
The Self Directed Installment Sale allows you to similarly defer your capital gains tax from the sale of your business. Instead of paying all of your capital gains at time of sale, you set up your SDIS to pay out your sale proceeds over time. If you pay all of your capital gains tax at time of sale, that money is gone forever. However, with this vehicle, you spread your receipt of the sales proceeds out over, 15 years for example. When you receive your distribution, you are then taxed for the portion of that distribution that is attributed to the capital gains - generally about 15%.
The difference in after tax proceeds are dramatic and are demonstrated by a complex analysis called an illustration. I will try in an abbreviated fashion, however, to demonstrate the potential impact. If you sold your business and you had a capital gain of $3.46 million, your lump sum capital gains tax payment at a 15% rate would be $519,000. In the SDIS you would keep the entire sale proceeds of $3.46 million and take distributions over a 20 year period or whatever period you chose. You receive an annual payment over 20 years, that would consist of 1/20 of the principal, 1/20 of the capital gains, plus investment returns.
If we did an illustration of this case and compared selling the business and paying all the capital gains up front and invested the remaining proceeds in a 6.85% compound growth portfolio versus the SDIS paying 1/20 of the capital gains annually, you would gain an $831,000 advantage in after tax proceeds. Not to bad for a little advanced planning.
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